Senior Convertible Note Definition

What Is a Senior Convertible Note?

A senior convertible note is a debt security that contains an option in which the note will be converted into a predefined amount of the issuer’s shares. A senior convertible note has priority over all other debt securities issued by the same organization. Just like any other debt investment, senior convertible notes offer investors the ability to earn interest. Rather than cash payments, however, the interest payments typically will accrue and the amount the company owes the investor will increase over time.

Both startup companies and well-established companies may opt to issue senior convertible notes to raise funds from investors. This type of company financing has the advantage of being fairly simple to execute. This means the process of issuing the notes is relatively inexpensive for companies and it allows them quicker access to investor funding. A downside to this quick access to investor funding is that companies may end up carrying excessive debt, which could push them into insolvency or bankruptcy.

Key Takeaways

A senior convertible note is a debt security that contains an option making the note convertible into a predefined amount of the issuer’s shares.

Both startup companies and established companies may choose to issue senior convertible notes as a means to raise funds from investors.

Investors of senior convertible notes benefit from the option to convert their notes into shares of the issuing company and from a priority for recourse if the issuing company goes bankrupt.

Some investors purchase senior convertible notes with the goal of reaping significant profits if the startup has a successful initial public offering (IPO) or is acquired by another company.

How a Senior Convertible Note Works

A senior convertible note is a type of convertible note. A convertible note is a debt instrument often used by angel or seed investors looking to fund an early-stage startup that has not been valued explicitly. After more information becomes available to establish a reasonable value for the company, convertible note investors can convert the note into equity. Investors have the option to exchange their notes for a predetermined number of shares in the issuing company.

The firm valuation will usually be determined during the Series A financing round. So instead of a return in the form of principal plus interest, the investor would receive equity in the company.

Senior Convertible Notes and Company Default

If the company fails after issuing a convertible note and defaults on its obligations, its noteholders will probably be unable to get their initial seed money or investment back. If there’s anything to be gotten, convertible noteholders will fall in line after secured debt holders and before shareholders.

While the lender in a senior convertible note agreement has the option of converting their notes to shares of the borrowing company, the lender also has a senior claim on the borrower’s assets in the event of bankruptcy.

Senior convertible notes have a maturity date, which is the date the notes are payable to investors if they have not already been converted to equity.

Benefits of Senior Convertible Notes

The senior convertible noteholder receives two benefits not found on a normal bond issue—a call option and priority for recourse if the issuer goes bankrupt. Due to these added benefits, the amount of interest offered to the noteholder will tend to be lower than on any other bond provided by the same issuer.

From an investor’s perspective, senior convertible notes can represent an opportunity to invest in the early stages of a startup with the potential to reap profits if there is a successful initial public offering (IPO) or acquisition. Investors who purchase senior convertible notes from an established company often are looking for an investment with a limited downside risk even if it comes at the expense of limiting upside potential as well.

Special Considerations

One concern with early-stage companies is the possibility they will not be able to continue to raise additional rounds of equity financing after issuing a senior convertible note. Because of this, these companies may not have the money to pay back noteholders at maturity if the notes fail to convert. Some investors may require contingency stipulations to offer some protection before investing in early-stage companies that are perceived to be higher risk.

The worst-case scenario of holding a senior convertible note would be if the issuing company initially performed well, meaning that the debt would be converted into shares, and subsequently went bankrupt. The converted shares would become worthless, but the holder of the note would no longer have any recourse.